Roth IRA Conversion Can Help Maximize Wealth Transfers

Converting pre-tax assets, such as those in a traditional
individual retirement account (IRA) or a 401(k) plan, into a Roth IRA can offer advantages for clients in a variety of financial circumstances.

According to a new Vanguard analysis, Roth conversions can help individuals avoid required minimum distributions (RMDs), for example. Depending on the individual client needs, there are a few ways to achieve this.

First, the firm says some investors can benefit from converting
pre-tax assets into a Roth IRA through a tax-exclusive option. This means that
the investor pays taxes due on conversion with assets outside the IRA or
401(k). “This is often the preferred strategy as it transfers the entire pre-tax
IRA balance to the Roth account, essentially increasing its after-tax value,”
Vanguard notes.

Obviously, paying these taxes with assets inside the account through
a tax-inclusive method leads to a smaller opening balance and potential for
growth, but often this may be the only choice.

Vanguard explains how the tax-exclusive conversion can support
beneficiaries inheriting these assets using a hypothetical 65-year-old investor
with a taxable account balance of $28,000, a traditional IRA balance of
$100,000, and a 40-year-old non-spouse beneficiary. Both are in the 28% tax
bracket and the following calculations assume no estate taxes are due at the
account owner’s death and the income tax rate for both parties remains constant
over time.

In the first scenario, the account owner maintains the
$100,000 traditional IRA and the $28,000 taxable account, reinvesting all
income and dividends. She begins taking RMDs at age 70.5 and reinvests the
after-tax proceeds in her taxable account. Upon inheriting the IRA, her
beneficiary begins taking RMDs according to his life expectancy and reinvests
them, net of taxes, into the taxable account.

In the next scenario, the account
owner converts the entire traditional IRA to a Roth IRA and pays the conversion
taxes from the IRA while maintaining the taxable account (a tax-inclusive Roth
conversion), leaving her with a $72,000 Roth IRA and a $28,000 taxable account.
She does not take any withdrawals from the Roth IRA during her lifetime. Upon inheriting
the Roth IRA, her beneficiary takes RMDs (income-tax free) based on his life expectancy
and invests them in the taxable account.

The next scenario is identical to
the last one, except the account owner pays the conversion taxes using the
money in her taxable account (a tax-exclusive Roth conversion with the full balance
converted), leaving her with $100,000 in her Roth IRA and no balance in her taxable
account.

Vanguard’s calculations determine
the account balances to be as follows after 30 years from conversion: $536,850
for the first scenario; $572,903 for the next scenario; and $602,461 for the
last one.

NEXT: Estate-planning advantages

Vanguard also offers insight into how conversion into a Roth
IRA can offer several estate-planning advantages. If an estate is large enough
to incur estate taxes, the beneficiaries are required to pay them on all assets
that don’t exceed the exemption point. This includes tax-deferred assets, traditional
IRAs, 401(k)s and other retirement plans. Furthermore, they must pay income tax
on any withdrawals form these accounts leading to double taxation.

“Thus, it is generally more advantageous
to pass assets that do not have an embedded income tax liability, such as a
Roth IRA or taxable assets,” Vanguard argues.

The firm also says “the estate can
be reduced by the conversion taxes paid and any future appreciation of those dollars.
Even if the reduction isn’t large (and many individuals are not subject to
estate tax at all), using this method does not reduce the owner’s gift/estate
tax exemption. However, because the investor’s estate will include the Roth IRA
(and its potential growth), a Roth conversion may increase a taxable estate
over time, possibly beyond the savings achieved by converting. For those with
sizable estates, it is especially important to consider all of the implications
before making a decision.”

The advantages of investing into a
Roth IRA largely depend on tax expectations, which can be extremely difficult
to determine. Generally speaking, a Roth IRA is potentially most useful for
investors who predict their income tax obligations would increase as they
approach retirement, because taxes avoided upon distribution would be larger
than those levied while making contributions to the account. The matter can
become more complex when planning across generations, highlighting the
importance of analyzing an individual’s particular goals for a retirement
account,